Can unemployment benefits raise joblessness?

Did the extension of unemployment compensation during the Great Recession cause joblessness to go up?

Economists have found two ways that extending unemployment benefits from the 26 weeks generally available in most states to up to 99 weeks could have caused unemployment to go up. First, that compensation can discourage workers from taking jobs. The worry, frequently heard on the political right, is that workers would rather stay home and enjoy leisure supported by government benefits rather than take available jobs. If that's true, then extending unemployment pay would cause workers, on average, to stay out of work longer.

The second way unemployment compensation could increase joblessness is by causing workers who would otherwise stop looking for work and immediately drop out of the labor force to instead stay in the labor force as job-hunters until their benefits run out.

However, economic research also says even if unemployment compensation does cause workers to remain jobless longer, that's not necessarily a bad thing.

Modern theories of unemployment are based upon the difficulty of finding productive matches between workers and companies. If workers are allowed to search longer, then a more efficient and productive match is likely to occur.

For example, imagine an electrical engineer who becomes unemployed, has lots and lots of bills to pay, and doesn't have enough savings to carry her for very long. That worker might be tempted to respond to a help wanted sign at McDonald's, or take some other job just to get income to the household.

And once the worker accepts a job that's below her abilities (economists call this being "underemployed"), it's hard to find the time to search for a job that's a better match for their training. Both the worker and society would be better off if the worker could find a new engineering job, but that takes time -- time that unemployment compensation can provide (and finding the right job will take even longer in a deep recession, hence the extension to unemployment benefits).

Thus, providing unemployment compensation entails a cost, but it can also provide the benefit of better matches between workers and jobs. The program should allow workers enough time to find a good match without being so generous as to cause them to live off the program without seriously searching for a job that matches their qualifications.

The latest research on this topic from Katharine Bradbury of the Federal Reserve Bank of Boston backs up these conclusions. As she noted, previous research on this question finds that unemployment does go up when unemployment benefits are extended, but the question is why. Does it discourage workers from taking jobs, or discourage them from leaving the labor force?

Bradbury pointed out that the earlier research shows it's mostly the latter, that extending unemployment benefits causes workers to stay in the labor force longer before dropping out. No notable impact was found on their willingness to take available jobs. Her study comes to a similar conclusion. In particular, quoting from her paper, her main results are:

"Unemployed job losers tend to remain unemployed until they exhaust UI [unemployment insurance] benefits, at which point they become more likely to drop out of the labor force; transitions to a job appear to be unaffected by UI benefit extensions. These findings imply that the longer periods of benefit eligibility under the [two primary federal programs] -- up to 99 weeks in many states in 2011 and 2012 -- contributed to the elevated jobless rates observed during that period, but not via lower employment."

What about the impact when those extended benefits ended? Bradbury came to this conclusion:

"By the same token, the sharp contraction of benefit weeks that occurred in 2012 and continued more gradually in 2013 likely contributed to declines in unemployment and participation rates beyond what one would expect based on the improving economy alone. Similarly, the December 28, 2013 sudden cutoff of federal UI payments to an estimated 1.3 million jobless Americans who had been looking for work for more than six months is adding to the pace of transitions from unemployment to dropping out of the labor force, thus reducing the unemployment rate and the labor force participation rate further in the first half of 2014, although very modestly."

This shouldn't be surprising. With the ratio of job seekers to available jobs as high as 7 to 1 during the recession, there simply weren't enough jobs for all of the workers who wanted them, and companies had no trouble finding workers willing to take the relatively few jobs that were available. Many of those who couldn't find work became discouraged and dropped out of the labor force once their unemployment benefits ended.

The big question for policymakers now is: How many of the workers who dropped out of the labor force will return once job market conditions improve? The latest unemployment report gives us some indication that many will return. As economist Dean Baker of the Center for Economic and Policy Research noted following the latest jobless report, "the unemployment rate [fell] to 6.1 percent, a new low for the recovery. This was due to people entering the labor force and finding jobs; the employment-to-population ratio rose to 59.0 percent. This is a new high for the recovery, but still 4.0 percentage points below its pre-recession level."

Even though the reentry of discouraged workers will make it harder to bring the unemployment rate down, the return of these workers is still good news. It's much better to have these individuals employed in productive activities rather than permanently staying out of the labor force.

If the return of discouraged workers continues in large numbers, it also implies that monetary policymakers will have to be careful not to remove policy accommodation too fast. The Federal Reserve is worried that rising wages due to a tightening labor market will cause price increases and elevated inflation rates. But if the labor supply increases due to the return of discouraged workers, that's much less of a concern.

Indeed, the latest employment report showed very little, if any upward wage pressure above and beyond what has been occurring for the last year or so. So, as long as wage growth is subdued, monetary policymakers can keep trying to stimulate job growth without worrying that inflation will become a problem.